It's On: Bondholder Groups Square Off Over Puerto Rico Financing

On Oct. 7, a group of hedge funds that hold the general obligation bonds of Puerto Rico amended an existing complaint (initially filed in July) in a significant respect: by adding a new defendant.

The new defendant is the issuer of the "COFINA" bonds, the Puerto Rico Sales Tax Financing Corp.

A head-to-head clash between the holders of GO bonds and the holders of COFINA bonds, a clash that has been in the works for a long time, is now officially … on.

COFINA, meaning both the financing corporation and the class of bonds it issues, have been around for 10 years now. Puerto Rico desperately needed revenue in 2006, and it was running up against its constitutional debt ceiling. The Commonwealth's constitution says that payment of principal and interest obligations under issued debt cannot exceed 15% of "average annual revenues raised under the provisions of Commonwealth legislation." Payments were approaching that limit a decade ago, and as-ever helpful Goldman Sachs stepped in with a plan. The COFINA bonds, issued by a quasi-private corporation and paid from a dedicated revenue stream, would not count against that 15%.

Voila! The deal was done.

The deal was done, sanctioned by Act No. 91, and the new corporation issued the bonds. Yet Puerto Rico continued over the coming years to lurch toward insolvency.

Debt levels expanded, nearly tripling, from $25 billion at the turn of the millennium to $73 billion 15 years later.

The flight of manufacturing is part of the reason for this quandary. In 1996 the Clinton administration and Congress agreed on a ten-year phase out of section 936, a tax break that had encouraged U.S. manufacturers to maintain operations on the island. In '96 there was a bipartisan consensus in Washington that phasing this out was a wise deficit-reduction move. Surely it is no coincidence that the crisis that demanded the creation of COFINA bonds came about just after the phasing-out of section 936 was completed.

In 2014, the legislature passed a Recovery Act, parts of which mirrored chapters 9 and 11 of the Federal Bankruptcy Code, creating court-managed restructuring processes.

In 2015, as default closed in on Puerto Rico, a working group mandated by the same Recovery Act developed a plan of action that entailed "the clawback of revenues supporting certain Commonwealth tax supported debt" which might be used to "service all principal and interest on debt that has a constitutional priority." This sounded to some of the COFINA bondholders like a threat to their distinct status as recipients of dedicated revenue.

That September, acting through their law firms, Quinn Emanuel and Orrick Herrington, the senior COFINA bondholders sent a collective letter to the island's Central Bank and fiscal agent, the Government Development Bank. The law firms demanded assurances of their clients' rights, and urged the GDB to do its "ministerial duty to untangle the COFINA debt and revenue from that of the Commonwealth."

In June of this year, the U.S. Supreme Court struck down the Recovery Act, holding that it is preempted by the federal bankruptcy system.

Since the SCOTUS Decision

But that system didn't really contain any measures that would address Puerto Rico's crisis, so Congress (effectively acting at the Supreme Court's invitation) stepped in with the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) signed into law later that month.

The law contains a section offering creditors "protection from inter-debtor transfers,"[407(a)] a section which may be interpreted as addressing such questions as the mingling of CODINA with Commonwealth asset pools.

This brings us back to where we began. In July, several management firms sued Governor Padilla under PROMESA to ensure that Puerto Rico continues to pay GO bondholders in full. Aurelius Capital Management, Autonomy Capital, Covalent Partners, FCO Advisors, Monarch Alternative, and Stone Lion Capital have now explicitly added COFINA, demanding that GO be given priority, essentially demanding precisely the mingling that Quinn Emanuel and Orrick Herrington were demanding assurances against in September 2015.